Why rising inflation is a genuine risk

Throughout 2021, fixed income investors are likely to keep a close eye on inflationary pressures — especially when it comes to U.S. exposure.

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“We think inflation is a bigger risk for fixed-income investors this year than we’ve seen in years past,” said Patrick O’Toole, vice-president of global fixed income at CIBC Asset Management, during a Jan. 11 interview.

Before the pandemic, O’Toole said he considered inflation expectations to be overblown: “We thought that the forces of demographics, technological innovation and excessive debt levels would all act to keep inflationary pressures and growth lower than the consensus expected.”

The U.S. Federal Reserve had rarely hit its 2% inflation target since the 2008 financial crisis. In September, the central bank changed its gauge to average inflation targeting, which means it’s now targeting 2% average inflation over an undetermined period of time, said O’Toole, who manages the CIBC Canadian Bond Fund and the Renaissance Corporate Bond Fund.

That means the Fed could allow inflation to exceed 2% for a given period without raising rates to slow the economy, he said.

The central bank has said it will keep its lending rate near zero until at least 2023 and chair Jerome Powell assured investors earlier this month that the Fed has no plans to pull back its bond-buying program.

The Fed could always change its mind in order to cap inflation pressure, O’Toole said, but the central bank will be watching what happens with the prices of goods and the services sector — the latter of which has been hit hardest amid the pandemic.

“The services sector has been very challenged in its pricing, but we think we’re going to get some pricing power back this year,” he said.

So what does this mean for investors monitoring inflation?

O’Toole said consensus expectations are for U.S. inflation of no more 2.5% in the second quarter before falling back below 2% in the second half of this year.

“We think that inflation will be pushing above 3% in the second quarter and maybe even hit 4% in that period. Then we expect that inflation will stay closer to 3% for the balance of the year,” O’Toole said.

If his forecasts are on the nose, “longer-term interest rates could drift higher, and they may hit a point that causes the Fed some discomfort that it’s losing control in keeping yields low enough to keep the economy moving forward.”

“The Fed could shift sooner than investors expect to reduce support for markets,” he said.

Yet, while inflation is “a genuine risk for the first time in decades,” O’Toole said, “I don’t think most investors really have to worry much about it.”

Investors who are diversified and have exposure to stocks and corporate bonds could benefit from government bond yields moving higher as the economy improves, he said.

“If yields are rising because inflation is rising more than expected, that would likely lead to a pretty similar result. If inflation isn’t a problem, their stock and bond returns should be relatively stable,” he said.

And while inflation is a threat right now, O’Toole said the longer-term trend should prevail.

“The long-run secular forces of demographics, technological innovation and excessive debt levels will reassert themselves in coming years to keep inflation and GDP pretty low,” he said.

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